Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Wednesday, March 30, 2011

Construing Delaware Law, Federal Appeals Court Rules Disclosure of Conflict of Interest Does Not Excuse Breach of Duty of Loyalty

A federal appeals court has ruled that a director’s disclosure of a conflict of interest does not excuse an alleged breach of fiduciary duty involving a duty of loyalty. It just excuses the conflict. To have a conflict and to be motivated by it to breach a duty of loyalty are two different things, reasoned a Seventh Circuit panel, the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus, a disloyal act is actionable even when a conflict of interest is not, said Judge Posner, one difference being that the conflict is disclosed and the disloyal act is not. CDX Liquidating Trust v. Venrock Associates, CA-7, No. 10-1953, Mar 29, 2011).

The case involved bridge loans made to the company that may have disadvantaged it in later attempts to sell the company. The director was also a director of one of the firms that made the bridge loans to the company.

Under Delaware law, when directors are sued for breach of their duty of loyalty or care to the shareholders, said the panel, their first line of defense is the business-judgment rule, which creates a presumption that a business decision, including a recommendation or vote by a corporate director, was made in good faith and with due care. But the presumption can be overcome by proof that the director breached fiduciary duties to the corporation, duties of loyalty and due care. If the business judgment rule is rebutted, the burden shifts to the defendant directors, the proponents of the challenged transaction, to prove to the trier of fact the entire fairness of the transaction to the shareholders. The shift to entire fairness makes sense in cases governed by the business judgment rule, reasoned the panel, since the rule creates such a commodious safe harbor for directors that overcoming it requires a very strong showing of misconduct.

Delaware law permits the shareholders to adopt a charter provision exculpating directors from liability in damages for failure to exercise due care, but does not enforce a provision exculpating them from liability for disloyalty. Thus, the compay’s articles of incorporation were not effective in waiving the director’s duty of loyalty, and so proof of their disloyal acts (had the jury been permitted to find that they’d indeed committed those acts) would have placed on them the burden of proving the entire fairness of the bridge loans.

There was enough proof that the alleged misconduct caused loss to company shareholders to make the issue of causation one for the jury no matter which side has the burden of proof. It was after the dot-com bubble burst, and only a few months before the company was sold for $55 million, that a similar company was sold for $300 million. The company could not hold out for a comparable deal because of the terms of the bridge loans. Thus, there was some evidence that company shareholders were hurt by director misconduct, over and above the hurt inflicted by events over which the defendants had no control.